This is What Happens During a Stock Market Crash

JUN 20, 2017

These temporary halts in trading, or “circuit breakers”, are measures approved by the SEC to calm down markets in the event of extreme volatility. The rules apply to NYSE, Nasdaq, and OTC markets, and were put in place following the events of Black Monday in 1987.

CIRCUIT BREAKER RULES

Previously, the Dow Jones Industrial Average (DJIA) was the bellwether for such market interventions.

However, the most recent rules apply to the whole market when a precipitous drop in the S&P 500 occurs:

Before Feb 2013

After Feb 2013

Index Tracked

DJIA

S&P 500

Level 1 Threshold

-10%

-7%

Level 2 Threshold

-20%

-13%

Level 3 Threshold

-30%

-20%

Upon reaching each of the two first thresholds, a 15-minute halt in trading is prompted. This is the case unless the drop happens in the last 35 minutes of trading.

Upon reaching the third threshold (-20% drop in S&P 500), the day’s trading is stopped altogether.

CAN CIRCUIT BREAKERS STOP A MARKET CRASH?

In theory, the use of circuit breakers can help curb panic-selling, as well as limit opportunities for massive gains (or losses) within a short time frame. Further, by creating a window where trading is paused, circuit breakers help make time for market makers and institutional traders to make rational decisions.

Regulators and exchanges hope that all of this together will give investors a chance to calm down, preventing the next market crash.

But do circuit breakers actually work? While they make logical sense, recent evidence from China paints a murkier picture.

To understand why circuit breakers can make markets less ‘safe,’ imagine that you’re a Chinese trader on a day when markets are approaching a five-per-cent decline. What do you do?

– Paul Kedrosky, The New Yorker

Kedrosky continues by explaining that a market participant in that situation would try to get as many sell orders in as possible, before the circuit breaker is triggered.

Further, when the markets re-open, the same trader would again sell immediately to avoid the second breaker (which triggers an end in trading for the day). Each time the breakers get triggered, it creates a market memory of the events, and traders try to avoid future shutdowns by selling faster.

PREPARATION IS KEY

Whether they work or not, it is essential for investors to understand the rules behind circuit breakers, as well as how markets think and react after these pauses in action.

In the event of a market crash, this preparation could help to make a difference.